Is it time to short CMBS?

As is the case with home equity asset-backed securities investors, those with an eye on commercial mortgage-backed securities share a couple of key concerns - shrinking credit enhancement levels and deteriorating underwriting standards.

And like the subprime RMBS sector, CMBS issuers have reached for excess loan volume to compensate for declining profit margins.

"CMBS has enjoyed a safe haven status for many years. Some CMBS investors may not be prepared for volatility," said Kim Diamond, a managing director at Standard & Poor's, in a report released last week.

But some are prepared. Along with reaching for value by incorporating new types of commercial real estate collateral and placing it into more complicated structures - such as CDOs - investors, as in the residential sector, are looking for new ways to short it. With much anticipation surrounding the approaching CMBX index and deepening liquidity within single-name CMBS credit default swaps, all eyes are on the sector's performance.

Amid what is expected to be another high volume year for CMBS, S&P is predicting that overall the amount of loans considered delinquent will remain stable. The sector will benefit from a continued flow of money and "healthy real estate fundamentals," S&P estimates.

The delinquency rate for CMBS, at 0.84% of outstanding loans, is anticipated to remain at or around the $3 billion mark.

The amount of upgrades the sector will see this year, however, is likely to be down from 2005, S&P estimates. Because credit enhancement levels have declined over the last several years, fewer later vintage deals are left to receive upgrades.

While credit performance is expected to remain stable this year, many are wondering how the changing characteristics of the CMBS sector will impact future performance.

"With subordination levels falling in spite of eroding credit dynamics, the creation of the super-senior and super-duper senior AAA' investor and continued repooling of below-investment grade securities into CDOs, one might ask, Who is reviewing the collateral and appropriately addressing the refinance risk in a CMBS pool?' " Dominion Bond Rating Service analysts recently wrote. "In essence, Who is minding the store?' "

DBRS found that with the creation of the super senior classes, a great deal of funding can pour into the CMBS structures with little due diligence on behalf of investors, ostensibly perpetuating poor collateral choices. According to Citigroup, triple-B CMBS investors should be analyzing every loan in the pool. The investment bank is anticipating a trend toward CMBS price tiering by underwriting standards and subordination levels, instead of issuer brand. Citi analysts wrote last week that new deals could have as little as 3.5% to 4.5% in credit support.

"With the much publicized relaxation in underwriting standards and the simultaneous contraction in credit support over the past couple of years, many investors have formed a negative view on non-AAA' CMBS, especially BBBs,' " wrote Lehman Brothers researchers last week.

Lehman researchers asked: how economical is it to take a short position on CMBS?

"After all," the researchers wrote, "buying protection is a negative-carry trade. Even after a weak credit is identified, the protection payments in the initial years can be material and be a deterrent to even the most pessimistic investor."

But there is always a level of default within the collateral pool that would make the sting of payments from the CDS protection buyer position worthwhile, Lehman wrote, referring to investors looking to short a particular security over a long-term horizon because of a fundamental view on its credit performance.

As the reference security ages, the amount of spread widening needed to compensate for a given month's protection payments increases incrementally. Assuming a 165 basis point premium payment, the cumulative widening to break even over a two-year period would have to be 56 basis points - 25 in the first year and 31 in the second, Lehman found. The lower the protection payment, or the higher one chooses to reference in the capital structure, the lower spreads need to widen to compensate.

To determine how poorly a given CMBS deal would have to perform to widen spreads enough to break even with protection payments, Lehman turned to the current credit curve in the CDS market. The investment bank found that a triple-B rated security would have to perform like a triple-B minus security in roughly three years for a triple-B protection buy to hypothetically break even. That would mean losses would have to reach, or come close to, 1% by year three. Similarly, a CDS on a single-A CMBS security would have to trade 58 basis points wider - like a triple-B - by year five for the trade to break even.

Since credit issues must be much higher to reach a break even point the higher one references in the capital structure, Lehman recommends buying protection on triple-B minus or double-B securities. The triple-B minus portion of the CMBS capital structure is likely the best part to buy protection on, Lehman said, while buying on double-Bs could make sense with an extremely negative credit outlook. Single-A credit protection might be worth it if default performance was expected to be volatile.